Under New Lease Standard: Interpreting ‘Class of Underlying Asset’
The Financial Accounting Standards Board (FASB) has issued several new Accounting Standards Codifications (ASC) and Accounting Standards Updates (ASU) over the past two years. This has resulted in management teams furiously working to understand and implement these new requirements. For many oil and gas companies, the effective date of ASC 842, Leases, is rapidly approaching and implementation efforts are straining personnel resources.
Since ASC 842 was initially proposed in February 2016, it has undergone a series of modifications, including three final ASUs and additional proposed updates, which have added new practical expedients and policy elections based on feedback from concerned registrants. The impact of the modifications to the standard have been significant, in particular for oil and gas companies. With only a month left from the effective date for most public business entities and additional modifications pending, it can feel like management teams are chasing a moving target.
Embedded in the new lease standard is a term that, at face value, appears to be innocuous – “class of underlying asset.” As management teams work to draft and finalize their accounting policies, a common question keeps coming up: what exactly is “a class of underlying asset?”
ASC 842 provides lessees with two practical expedients that may be elected as an accounting policy by “class of underlying asset”:
- ASC 842-10-15-37 allows lessees to not separate lease and non-lease components.
- ASC 842-20-25-2 allows lessees to not recognize lease liabilities and right-of-use assets for short-term leases.
Lessors are afforded the same ability to not recognize lease liabilities and right-of-use assets for short-term leases by class of underlying asset (ASC 842-20-25-2). Initially, the practical expedient in ASC 842-10-15-37 was not available to lessors; however, amendments directed by the FASB earlier this year and issued in July 2018 in ASU 2018-11 provide for a practical expedient allowing lessors to elect, by class of underlying asset, to not separate lease and non-lease components. However, unlike the lessee practical expedient, the lessor practical expedient can only be elected if certain criteria are met and requires a lessor to disclose (1) that it has elected the expedient and (2) the nature of the items that are being combined.
Based on a review of Staff Accounting Bulletin (SAB) 74 disclosures issued subsequent to ASU 2018-11 becoming effective, several oil and gas companies plan to elect one or both practical expedients in their accounting policies by class of underlying asset.
So, What Is a Class of Underlying Asset?
ASC 842 does not provide a definition for what comprises “a class of underlying asset”. Historically the financial term, “class of underlying asset”, was used to describe the security, property or other asset that gave value to a derivative instrument. Now, the term represents the unit of account for several significant accounting policy elections within the new lease standard. In the absence of a definitive definition, entities must proceed with their best interpretations.
ASC 360-10-50 requires disclosures of “…balances of major classes of depreciable assets, by nature or function….” Intuitively, determining classes of underlying assets should be straightforward based on the physical nature and characteristics of the asset(s). For example, the Master Glossary defines an intangible asset class as “a group of intangible assets that are similar, either by their nature or by their use in the operations of an entity.” Using a similar fact pattern, real estate, rental equipment and vehicles would all be reasonable classes of underlying assets given their physical nature. An issue arises, however, because, unlike grouping similar assets for depreciation purposes, leased assets can have widely varying risk and use profiles even while sharing similar physical natures.
An alternative approach would be to identify classes of underlying assets on the basis of the risks and uses associated with the asset. This approach may be preferable based on comments made by the FASB in paragraph BC341 of ASU 2016-02, which states: “In the Board’s view, leased assets often are subject to different risks than owned assets that are held and used (for example, the decrease in the value of the underlying asset in a lease could be due to several factors that are not within the control of the lessor), and, therefore, users will benefit from lessors segregating their disclosures related to assets subject to operating leases from disclosures related to other owned property, plant and equipment. The Board further considered that to provide useful information to users, the lessor should disaggregate its disclosures in this regard by significant class of underlying asset subject to lease because the risk related to one class of underlying asset (for example, airplanes) may be very different from another (for example, land or buildings).”
While an asset’s physical nature may be similar to that of other assets, such as oilfield rental equipment (i.e., compressors, light towers, forklifts, pumps, etc.), each have a different purpose and use to the lessee and could have a separate risk profile. Another illustration of this view includes leased real estate, which could include office, field and easement leases. The risk profile and use of an office lease differs from that of an easement lease. Therefore, it could be appropriate for the entity to disaggregate rental equipment or real estate leases into separate asset classes by “type” of equipment or real estate — to the extent that the different types are subject to different risks — when applying the available practical expedients. It is generally accepted that different lease terms and conditions within the same type of asset (for instance, a term contract for a drilling rig versus a spot contract) do not define a class of underlying asset for the purpose of electing a practical expedient.
For lessors, the categorization of class of underlying asset will probably be more straightforward as the various asset classes likely represent defined revenue streams (such as vehicle rentals, well completion services, drilling services, tool rentals, etc.). Existing business processes and systems can be leveraged depending on the policy election(s) made. In addition, lessors will generally have an easier ability to bifurcate the standalone selling price of the lease and non-lease components in their agreements, which can assist in determining policy elections by underlying asset class.
For lessees, the identification of classes of underlying assets may prove more difficult. Under previous lease guidance, several rental or service agreements were never considered to contain a lease component. Now under ASC 842, entities are faced with not only identifying new leases but defining new underlying classes of assets depending on the policy elections they choose. In order to comply with ASC 842, including the expanded disclosure requirements, entities may need to modify their current business, system and control processes to account for newly identified classes of underlying assets.
For most oil and gas companies, the implementation of ASC 842 will require a significant amount of effort to:
- Apply the revised definition of a lease;
- Compile a complete population of leases; and
- Select and implement the various practical expedients available based on their unique facts and circumstances.
Entities will need to be thoughtful and proactive in their identification of classes of underlying assets. Input from all stakeholders will be important, as well as leveraging technology solutions. Initial policy elections will be subject to review by external auditors and, in many cases, required to be disclosed. As such, close collaboration between management and their accounting advisors is important in order to make appropriate determinations as the new standard’s effective date rapidly approaches.